Bringing real assets to 401(k)s

AUG 24, 2012
In recent years, many defined-contribution plans have used target date funds as the default option of choice. But few of these funds reach beyond the traditional stock and bond asset allocation model, adjusted periodically for the participant's years to retirement. And even fewer address the need for inflation protection, a critical objective of the long-term saver, especially when retirement is approaching and income is waning. As fiduciaries, DC plan administrators may recognize the merits of real-asset categories, based on their inflation-fighting characteristics and diversification potential. But there are some investment implications — namely, single-asset-class solutions can be volatile and drive performance-chasing behaviors. So ideally, a plan's real-assets/ real-return investment option is diversified among critical components, creating a smoother return profile across economic cycles. A simplified, single solution also avoids the confusion and participant inactivity caused by menu clutter.

RECOGNIZE THE REAL

Cohen & Steers Inc. has conducted extensive research into the inflation-fighting merits of real assets as a portfolio complement to stocks and bonds. As we researched the historical drivers of inflation, our focus turned to tangible-real-asset classes. But from an allocation perspective, we found that the optimal combination included portfolio diversifiers for enhanced stability. This led to the construction of a diversified-real-assets framework that includes the following: Commodities. With the underlying dynamics of demand, supply, production and the commodity futures market structure, commodity sectors such as energy, industrial and precious metals, agriculture and livestock tend to perform well during periods of rising inflation. From an investment perspective, commodities have shown a low correlation with stocks and bonds, which points to the diversification potential of this asset class. Natural resources equities. As we layer on other dynamics — increasingly erratic weather patterns, natural disasters and global population growth — a potentially dynamic macroinvesting case emerges in a number of natural resources industry groups: energy, metals and mining, and agriculture. REITs. The majority of the replacement cost for commercial real estate is represented by the sum of the commodities and energy needed to build it. We have watched commodities prices rise sharply over the past two years, but commercial real estate has yet to recover fully from its precipitous drop in the financial crisis. In many sectors, commercial real estate continues to be valued at a significant discount to replacement cost. Historically, the dividend growth of real estate investment trusts has well exceeded the pace of inflation, adding to their inflation-fighting ability. Variable-rate notes. Portfolio diversifiers such as Treasury bills and high-grade variable-rate notes can provide portfolio stability and generate some income, while not subjecting a real-assets portfolio to the level of interest rate risk typically found in periods of rising inflation. Denominating these issues in foreign currencies, such as the Australian and Canadian dollars, can enhance these benefits. Gold. In addition to its commodity value, gold can serve as an antidote to expansive monetary policy, economic dislocation and geopolitical instability. It has always been a recognized store of value relative to fiat currency based on its liquidity, acceptability as a medium of exchange, and portability. As such, gold can be an effective portfolio diversifier, offering complementary performance characteristics relative to other real-asset categories and a hedge against a declining dollar. Within this framework, our research points to higher weights for commodities and REITs (25%-35%), based on their relatively low correlations with one another and attractive return potential across different economic environments. Generally, more volatile sectors such as natural resources equities would prescribe lower weightings (15%-25%). Portfolio diversifiers such as variable-rate notes and gold would get weightings of 5%-20% and 0%-15%, respectively. Yigal D. Jhirad is a senior vice president and portfolio manager, and Anthony Ialeggio is a senior vice president and director of global marketing, at Cohen & Steers Inc.

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